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Rational route to investment returns (Summary of Presentations)

Think you make considered and rational choices when it comes to your investments? Well even the members of a financially knowledgeable audience were given pause for thought when Professor Utpal Bhattacharya and Professor Philip Cheng from HKUST’s Department of Finance shared their research findings and ideas at the first of the Business School’s Lunch Presentation Series 2018.

Their always fascinating, and frequently amusing, lunchtime seminar was titled ‘How different factors affect financial behavior and portfolio management’. While Professor Bhattacharya pointed out some of the psychological pitfalls to avoid when investing, Professor Cheng outlined a more reliable and profitable strategy than those usually used by private investors.

Psychology and Finance

Behavioral finance specialist Professor Bhattacharya is a non-believer when it comes to the notion of rational finance. Instead he takes insights from cognitive psychology to explain puzzling asset price fluctuations. In his talk, he illustrated his ideas through three examples from his research.

First he explained how the effectiveness of common pricing practices – with supermarkets, for example, selling items for US$6.99 rather than US$7 - stems from an understanding of the ‘anchoring’ strategy used by consumers when overloaded with information.

“Anchoring describes the common human tendency to rely excessively on the first piece of information - the anchor - when making decisions,” he said. In the case of pricing it’s the left-digit effect. So even though there is only a one cent difference between $6.99 and $7.00, the former seems much more appealing.

And it isn’t just the supermarket shopper who is susceptible to this non-rational approach. Professor Bhattacharya looked at 130 million transactions on the NYSE. “Most of the buys took place at .99 prices and most of the sells took place at .01.” In other words, figures just over and under the round number.

The professor went on to point out, even though superstition is a global not just a Chinese phenomenon, when he studied the prices submitted on Taiwan’s stock market, he found a clear preference among local individual investors, as opposed to institutions and foreigners, for the number eight and a dislike for the number four. He also found that, “the most superstitious investors lose the most money.”

In his third example, Professor Bhattacharya studied the depressing effect of the so-called ‘haunted house’ phenomena on the price of Hong Kong apartments. “We found the ripple effect of haunted houses on prices, was a drop of 20 percent for affected units, five percent for units on the affected floor, three percent for units in the affected block, and one percent for units in the affected estate.”

After noting this ripple effect was strongest for the sites of murders, Professor Bhattacharya ended his address by warning his audience to remember, “we live in the real world which may not be the ideal world where reason reigns.”

Successful personal portfolio management

Prior to joining academia, Professor Cheng had already enjoyed a successful career in the finance sector, with MetLife and JP Morgan Chase. He is, therefore, well aware of the advantage professional investment managers have over the individual investor, both in terms of experience and the amount of time available for portfolio management. However, Professor Cheng aimed to narrow this gap in his presentation, which was based on ideas outlined in his bestselling book, Taming the Money Sharks.

Framed in terms of eight key points, each with its own accompanying axiom, he set out a calmer, more rational route to reducing losses and maximizing gains.

When deciding which areas to buy into, Professor Cheng advised the members of his audience to work from their strengths by focusing their investments on the sector or industry they already they knew the most about.

He also urged them to build on this initial knowledge by, say, listening to experts and reliable media sources. He did sound a note of caution, however, suggesting personal investors verify information received. “There is an old saying, that behind every message there may be a position.”

Once the sector has been decided on, Professor Cheng recommended that, before picking a particular stock, they look at the fundamentals and financial statements, over a minimum of a three year period, of the companies they are evaluating.

Of the tens of indicators that could be considered when decided what and when to buy, as well as when, subsequently, to sell, Professor Cheng listed five, and highlighted two. “Gross profit margin is a good start as this has an indicative level for every industry,” he said, adding that the net core cash flow in dollars is also very telling.

When it comes to the psychology of portfolio management, he advocated taking a long-term approach and to avoid chasing the hot stocks and trends. “Don't rush as money will always be there if your process is sound,” he said.

He finished by pointing out it was a mistake to ever ‘fall in love’ with a particular stock, or to put one’s investment lifestyle ahead of one’s health.